Earnings Call: Q4 2016

Mar 29, 2016

2015 was another year of record performance for RH. We reported record net revenues of 2,100,000,000 dollars up 13% on top of a 20% increase a year ago and up nearly $1,000,000,000 from our initial public offering in November of 2012. Our adjusted operating income grew 18% to $205,000,000 on top of a 43% increase last year. Adjusted operating margins reached a record 9.7%, among the highest in our industry and up from 5.8% at the time of our public offering just 3 years ago. While pleased with our full year performance, the difficulties we experienced in the Q4 indicate we are operating in a different market than a year ago and believe it requires us to adjust our strategies to optimize performance in the short term, while positioning the company for long term value creation. Let me address what we are seeing and consequently, how we are thinking and operating differently. There are 3 key factors that had a negative effect on our Q4 results, along with several positive developments to give us tremendous confidence in our long term growth strategy. 1st, our demand sales or written orders were up a strong 21% in the 4th quarter on top of 26% last year. Our delivered net revenue, however, was only up 11% in the quarter on top of 24% last year, representing a shortfall to our plan. While the initial response to RH Modern has been outstanding, we are experiencing shipping delays as certain vendors are struggling to ramp up production on this new product line. While we expect the majority of the orders to turn into revenues in the first half, we are, however, experiencing higher cancel rates and onetime costs due to shipping delays, which will put pressure on both revenue and earnings in the first half. While expensive in the short term, we believe it is the right thing to do for our customers, not only to retain them, but to create long term advocacy for our brand. 2nd, we continue to see underperformance in the markets affected by energy, oil or currency fluctuations, specifically Texas, Miami and Canada. These markets were a 2 point drag to total company revenues in the first half and accelerated to 4 points in the second half despite increased promotional efforts. The results indicate that the conditions continue to deteriorate and our trends thus far in the Q1 are resulting in a drag of 5 points. 3rd, our attempt to drive incremental revenue through increased promotional activity in the 4th quarter were less successful than in prior periods. Our sense is the increased volatility in the U. S. Stock markets, especially at the extreme conditions in January, which is historically our biggest furniture month of the quarter, negatively impacted our performance. While there is certainly a fair amount of bad news in the quarter, we believe the good news outweighs the bad when you put it into the context of our long term growth strategy. Despite the economic headwinds, our 2 value driving strategies, the expansion of our product offer and the transformation of our real estate are working exceptionally well. The strong response to RH Modern, both in retail and direct, indicates that this can quickly become a $1,000,000,000 plus brand. Our first standalone gallery in Los Angeles is on trend to achieve $25,000,000 in demand sales in its 1st year. And the full floor presentations in our next generation design galleries are performing exceedingly well. In addition, the launch of our H team is off to an exciting start, and we expect this new business to continue building momentum as we expand the product offer and retail presence. As it relates to our 2nd key value driving strategy, the transformation of our real estate, all of our next generation design galleries are exceeding plan. With the 1 year anniversary of Atlanta plus the openings of Chicago, Denver and Tampa, we continue to demonstrate that our strategy to transform our 7,500 Square Foot Legacy Stores into 45,000 to 60,000 Square Foot Next Generation Design Galleries will drive meaningful growth over the next 7 to 10 years. Our ability to blur the lines between residential and retail, indoors and outdoors, physical and digital, creating an immersive environment that is more home than store, is producing industry leading results and positioning RH as the clear leader in the luxury home furnishings market. Our new gallery at the historic 3 Arts Club in Chicago further blurs the lines between home and hospitality with a beautiful central courtyard cafe, wine vault, pantry and coffee bar. The gallery also includes our 1st design atelier, a fully developed workspace for architects, designers and clients to imagine and design their own personal spaces. It further enhances our position as a design authority as we continue to build out our interior design services platform. We believe RH Chicago represents the future of experiential retail. It proves we can drive traffic and create a destination, making us an even more valuable tenant to developers. Now let me turn to our priorities for 2016. First, we believe we have a tremendous opportunity to optimize our core business. Our energies in the first half of twenty sixteen are focused on ramping production and improving in stocks for H. Modern. We believe demand will continue to build as our inventory position strengthens. We expand the assortment and grow our retail footprint later this year. We plan to mail RH Modern with our annual RH Interior Source book this fall, allowing our vendors time to ramp up production on new collections. This should improve in stocks, reduce back orders and dramatically enhance the customer experience. We recently mailed our new RH Outdoor source book, featuring new collections and new branding by Fabian Baron, who designed the RH Modern source book. We believe the new design gives the book a fresh and contemporary point of view. Our second priority this year is changing our promotional cadence and elevating the RH brand. This month, we launched the RH Graycard. For an annual fee, members receive a 25% discount, free interior design services, access to concierge, preferred financing term and other benefits. While early, the initial adoption rates and customer feedback are very encouraging. Let me share some context on why we made the decision to move to a membership program. Much of how we behave promotionally was left over from the Great Recession. The multiple sale events and email communications did not reflect the brand we are building, nor will those promotions aligned with how our customers shop with us. Our business has evolved from a product based business to a project based business. Our customers want to shop for what they want, when they want and receive the greatest value. Not only do we believe this model is the right thing for our customers, but also believe it's the right thing to do for our business. By smoothing out our revenues, we'll both improve execution and reduce costs throughout our operating platform. Eliminating the weekly promotions will allow us to repurpose our e mail marketing to messages and design authority and product quality. It also brings pricing transparency to all of our channels. Now member pricing will be prominently displayed in our source books, website and galleries, which we believe will more firmly establish the outstanding value proposition of the RH brand. We believe this move to a transparent membership model will prove to be the right one for our brand, our business and our customers. Our 3rd priority this year is elevating the customer experience. As we've elevated our brand, especially at retail, other customer touch points also need to leapfrog forward to create a cohesive customer experience. The initiative will focus on investments from product quality to in home delivery across all channels, including new people, processes and systems. Our 4th priority is to optimize our inventory and working capital. We believe there is a significant opportunity to improve inventory turns and free up cash. During our most significant years of product expansion, we have not been as disciplined about inventory optimization, both in terms of assortment dynamics and supply chain efficiency. We have begun the process to rationalize our SKU count, editing underperforming products and simplifying our network design. Due to the low turn nature of many of our categories, our analysis would suggest there is an opportunity to be more efficient, increasing turns and reducing working capital over the next several years. Our 5th priority is to be selective and opportunistic with real estate. In times of market dislocation, asset values in real estate generally come down and we plan to take advantage of this likely outcome for the long term benefit of our business. Lower real estate costs translate into higher operating margins and ROIC and believe we are in a strong financial position to take advantage of the anticipated opportunities. At RH, our most significant transformative moves have occurred during periods of uncertainty. We came out of the Great Recession, a much stronger brand and business than when we entered. Despite the uncertainty, our underlying fundamentals are very strong. We continue to have the highest sales and earnings growth in our industry. We've expanded our operating margins to nearly 10%, among the best of our peer group. We have a dynamic multi channel platform that gives us all the advantages of online without the limitations of a single channel competitor. We are opening immersive spaces that are redefining physical retailing in the age of the Internet. History has taught us that real value is created by those who have the courage to lead rather than follow. We're willing to destroy today's reality to create tomorrow's future. At our core, we are innovators. We obsessively look for opportunities to destroy the current version of ourselves to create something significantly more valuable. Brands and businesses like people become great, not because they do not have failures or fears, but because they continue on despite them. I want to thank all of our team members and partners around the world for your passion and commitment to our cause and remind you, this is just the beginning of what we believe will be one of the most significant retail transformations of our time. Onward. We continue to make transformative changes to evolve and improve our business model in order to create long term shareholder value. Despite falling short of our plan, our fiscal 2015 results once again demonstrate the disruptive nature of the RH brand and our ability to gain meaningful market share amidst an uncertain market and highly competitive landscape, while expanding our operating margins. We reported record net revenues in fiscal 2015 of $2,100,000,000 up 13%, which was on top of 20% increase last year. This increase was achieved despite a significant decrease in our circulated pages and with the majority of our product introductions and newness as well as all of our new store openings late in the year. Comparable brand revenues increased 11% on top of a 20% increase last year. Adjusted earnings per share grew 15% to $2.72 on top of a 38% increase last year, outpacing our Home Furnishings peers. Our balance sheet is strong and we are well positioned to execute on our key growth strategies regardless of market conditions. We have now successfully completed 2 zero interest convertible debt offerings, strengthening our balance sheet and putting us in a position to take advantage of the opportunities that present themselves in difficult markets. We are ending fiscal year 2015 with over $500,000,000 in cash and investments on our balance sheet and a zero balance on our $600,000,000 line of credit. It has been clear to us watching the success of others that those with capital in difficult markets are generally those who capitalize. Inventory growth of 30% at the end of fiscal 2015 significantly outpaced our revenue growth for the year, primarily due to the addition of our new Northern California distribution center and lower than expected revenue during the Q4. We believe that inventory growth will moderate substantially this year as we do not plan to introduce any new businesses. Our newness will be introduced during the second half consistent with 2015 and based on our plans to optimize our current product assortment and improve inventory turns. Capital expenditures were $154,000,000 in fiscal 2015, in line with our plan of $140,000,000 to $160,000,000 in spend, largely driven by our real estate activity and the investment in our new Northern California DC. For fiscal 2016, we expect capital expenditures to be in the range of $175,000,000 to $200,000,000 largely driven by capital commitments for the next generation design galleries we expect to open in both 2016 2017. Let me now turn to our outlook. The trends in our core business are stable and we are pleased with the initial adoption of the RH Gray Card. However, we have seen an increase in cancellation rates due to our RH Modern production delays and our in stocks will not reach optimal levels until the end of the second quarter. Both of these factors are suppressing revenue during the first half of the year. In addition, quarter to date, we are experiencing weakening trends in the markets impacted by currency and energy related consumer spend as well as overall softness in spending by the luxury consumer. We are investing approximately $8,000,000 to $10,000,000 during the Q1 due to higher cancellation rates, shipping delays and our overall initiative to elevate the customer experience. While expensive in the short term, we believe it is the right thing to do for our customers and the long term advocates of our brand. We anticipate that these investments will moderate by the end of the second quarter as we reach optimal in stock levels for RH Modern and improve our execution. Including this investment, our first quarter revenues are expected to increase in the range of 7% to 8% on top of 15% last year to a range of $452,000,000 to $456,000,000 As the majority of the accommodations made to our customers impact revenue, adjusting for this investment, 1st quarter revenue outlook would have been growth in the range of 9% to 10% on top of 15% last year. 1st quarter adjusted EPS is expected to be in the range of $0.04 to $0.06 including approximately $0.12 to $0.15 per share related to our investments in the customer experience. Excluding this investment, adjusted EPS growth would be roughly flat with last year. While the initial response to RH Grade Card has been strong, we have yet to comp against a big promotional event from the prior year. We will continue to monitor sales over the next few quarters to read the trends and data as to what the natural waterline is for our business now that we are smoothing out the prior peaks and valleys created by our promotional activities. Based on this and the uncertain market conditions, we are expecting total revenues for the year to grow in the low to mid single digits. Due to the investments we are making in our service experience and based on the production and shipping delays related to RH Modern, we are expecting adjusted diluted EPS to be roughly flat to slightly down versus last year. Excluding these investments, adjusted diluted EPS growth would be in the mid single digit range. There are some key drivers that are important to consider as it relates to how to think about this year. First, we do not plan on launching any meaningful product newness in the first half, as we've made the decision to push our annual spring interior source book mailing to the fall. Revenue growth in the front half of fiscal twenty sixteen will be driven by our core business and the new stores opened at the end of 2015. Improvement in conversion of RH Modern as the 2015 orders turn into delivered revenue as well as stronger overall modern demand as our in stock levels improve the wrap of RH Teen and the incremental newness in our outdoor assortment and source book. 2nd, we expect fiscal 2016 weighted average lease selling square footage growth of approximately 20% compared to 12% last year. We expect to have approximately 40 new store months as we benefit from the stores that we opened in fiscal 2015 plus the addition of the 4 galleries we expect to open in late fiscal 2016. New store months are expected to then accelerate to a range of 60 to 70 months in fiscal 2017. We had previously expected 6 new stores in fiscal 2016. However, development at our West Palm Beach and Toronto locations has been delayed and has pushed our expected opening dates to fiscal 2017. In addition, it is important to note that the next generation design galleries opening this year in Leawood, Austin, Las Vegas and Seattle are all expected to open late in the 3rd 4th quarters, therefore providing a very limited contribution to our second half twenty sixteen revenue. We have 7 leases signed in the pipeline for 2017 and beyond and continue to believe there's an opportunity to open next generation design galleries in 60 to 70 markets over time. 3rd, as previously mentioned, we do expect to continue to have investments in the customer experience as well as accommodations for those customers impacted by production and shipping delays related to RH Modern through the first half of fiscal twenty sixteen. We believe that these are the right investments to make. It is the right thing to do for our customers and for our brand. The customer accommodations are an offset to revenue and will be coupled with investments in our systems, processes and people in order to improve our entire customer experience from beginning to end. While we have experienced near term headwinds, our long term strategies are intact and we have tremendous confidence in the long term opportunity to reach $4,000,000,000 to $5,000,000,000 in North American sales and mid teens operating margins. We are committed to making the necessary improvements in our business model to continue to improve our returns on invested capital and to deliver significant shareholder value over time.